The financial crisis of 2007 eroded the public confidence in financial markets. Many people have come to believe that only the government can guarantee the stability of financial markets. Responding to increased public demand, politicians from across the political spectrum support additional “macroprudential regulation”. However, little is known about the consequences of the newly proposed regulatory efforts. When politicians fear unforeseen consequences of regulation, they might turn to Placebo-regulation, which is some regulation that merely provides a warm glow for the general public. Given the widespread belief in the need for government regulation, we suggest that such Placebo-regulation may be a good option. Market distortions are avoided. But confidence in financial markets might be restored.

High-speed broadband networks are key to the growth of digital markets as well as most modern forms of communication, and have been subject to far-reaching regulation in many countries. In this piece, we’ll review the rationale behind a cornerstone of the prevailing regulatory paradigm: forced access to incumbent operators’ network infrastructure by alternative operators on regulated terms, so-called “unbundling”.

The big theme is nonlinearity, which is a profoundly conservative move: DSGE modeling is just fine and we don’t need to rethink it at all. We just need to add in some nonlinearities. Blanchard does not tell how to calibrate a model with extreme sensitivity to initial conditions. But if the system is chaotic, it is also unpredictable, so how can you pretend to merely add nonlinearities to DSGE models? It seems like a pretty direct contradiction to me. I mean, you can have the model in a trivial sense, of course. But calibration is an empty exercise that will not let you look around corners.

Blanchard’s second main message is alarming: We do need theoretical innovation, however, in measuring systemic risk. In the modern network literature on financial markets and cascades, one key point is risk externality. My portfolio choice makes your portfolio riskier. We need two things to fix this market failure. First, we need Pigou taxes, which cannot be calculated unless everyone tells the regulator his portfolio so that it can measure systemic risk and calculate a separate Pigou tax for each financial institution. Second, we need to reduce systemic risk. (“[S]teps must be taken to reduce risk and increase distance” from the “dark corners” of the macro-finance system.) In the network literature I suspect Blanchard is alluding to, this is to be done (at least in some of the articles) by having the regulator directly control the portfolios of financial institutions. (Names include: Acharya 2009; Beale et al. 2011; Caccioli et al. 2011; Gai, Haldane,and Kapadia 2011; Haldane and May 2011; and Yellen 2009, 2011)

Overall, Blanchard’s message is meant to be reassuring: We the smart macro-finance experts have now got the message on nonlinearities. So no further need to worry, we’ve got the situation in hand. To keep the system out of the “dark corners,” however, we will need more discretionary authority. You don’t mind trading off a bit of financial freedom for greater financial safety do you?

For the month of November, Cato Unbound features an essay by me on “The Fed at 100.” Over the course of a week, there will be comments by Larry White, Scott Sumner and Jerry Jordan. I will respond to these as appropriate.

“End the Fed” has become a political slogan. Long before that, however, there was a serious academic literature on the prospects for competitive banking. I examine that literature in my posting. One interesting aspect of that literature is that important papers on free banking came out of Federal Reserve banks in the 1980s.

I argue that “the literature on free banking demonstrates the viability of private, competitive banking without a central bank.” But we now have a system of central banking almost everywhere. The fact that the road not taken would have been a viable path does not mean that we can retrace our steps and take that path now.

I devote roughly half the posting to consideration of what it would take to end the Fed. It would be a formidable but not impossible task. It is generally acknowledged that to be viable, a system of competing currencies would need convertibility into something that is in inelastic supply. Historically that has been a commodity, and I suggest gold is as good as any (though many disagree about that). What are the prospects for a return to a commodity standard?

Central banking is historically linked to governments running deficits and needing them to be financed. That is equally true today. Central banks cannot be abolished until permanent deficits are abolished, and governments are shrunk down in size. What are the prospects for that?

I have just returned from a very important conference at the Mercatus Institute at George Mason University on “Instead of the Fed: Past and Present Alternatives to the Federal Reserve System.” As the title suggests, alternatives to central banking in the past and the future were discussed. All three discussants of my posting also participated in important roles at that conference. I was a discussant of three papers, including one by Scott Sumner. So I imagine we will be continuing our dialog at Cato Unbound.

One of the most interesting discussions was among advocates of Fed abolishment and of Fed reform. All agreed that we need better monetary policy now and into the future, regardless of our differences on the issue of free banking versus central banking. I will observe that it was encouraging that people as diverse as George Selgin, Scott Sumner, Ben McCallum and I were able to arrive at a consensus.

Income inequality matters. Let me say that again so you know I meant it: Income inequality matters. This statement may be surprising coming from a self-described “Austrian” economist and a “liberal” in the good old-fashioned pro-market sense. It shouldn’t be. It should be one of ourissues. The surprise should be that we pro-market types have not spoken up more on this central issue, thereby letting it become associated almost exclusively with more or less “progressive” opinion.

This indifference to income distribution is all the more mysterious because pro-market thinkers generally support a theory of politics that tells us to watch out for ways the state can be used to create unjust privileges for some at the expense of others. We should expect the distribution of income to be skewed toward the politically powerful and away from the poor and politically weak. In a representative democracy “special interests” engage in “rent seeking” to get special favors. Those special favors enrich some at the expense of others. That’s what they are meant to do! Continue reading →

Paul Ryan is said to be influenced by Milton Friedman, Friedrich von Hayek and Ayn Rand. One might add that as the representative for Wisconsin’s first congressional district, he is from a state that has often been in the vanguard of policy thinking. Continue reading →

Over at New APPS, the philosopher Eric Schliesser summarizes the eight comments. “Bottom line: due to low cost computing and a data rich environment the future of economics is data-mining (this was clear from at least four of the comments). This is especially so because the young stars have lost faith in homo economicus (due to behavioral work and the crisis).”

Eric’s summary seems about right to me. There were eight fine minds sharing eight different visions, but two related themes dominated the comments. 1) The old rationality assumption is in trouble and we don’t quite know what to do about it. 2) Economics should be more data-driven now that we have what William Brock has labeled “dirt-cheap computing.” Continue reading →

Some time ago I was accused by the noted economist and psychiatrist Professor Bradford DeLong of being a “psychopath” and “clinically crazy” because I suggested that people should not tip cab drivers in New York City. I do not intend to revisit that particular issue here.

This time I would like to take on the Taxi and Limousine Commission’s approval of a 17% fare increase for cab rides beginning in September. Continue reading →

After all that’s been said and written about financial crises, it is rare to come across useful insights. Financing Failure. A Century of Bailouts by Vern McKinley documents a major continuity with past policy making. He shows that policies intended to prop up failing companies are nothing new—the same basic pattern has recurred time and again.

But there is one notable change: the bailouts grew ever larger and the agencies concerned with them ever more numerous. Anyone thinking about recent crises and future prospects would do well to keep these points in mind. Continue reading →

The Supreme Court upheld “Obamacare” because Chief Justice Roberts changed his mind. (It seems that “Obamacare” is no longer a pejorative.) In this curious situation, a stalwart of the Federalist Society has become a Big Player in healthcare markets.

A Big Player is a powerful actor who uses discretion to influence a market. In the long run, Big Players are government entities or the creations thereof. They are discretionary actors whose personal discretionary choices supplant known and simple rules. In other words, Big Players substitute the rule of men for the rule of law. The great theorist of the rule of law, A.V. Dicey, said in an important remark that the rule of law “means, in the first place, the absolute supremacy or predominance of regular law as opposed to the influence of arbitrary power, and excludes the existence of arbitrariness, of prerogative, or even of wide discretionary authority on the part of the government.”

Roberts has become a Big Player, and yet the Federalist Society is against that sort of thing. It is committed to the rule of law. Its attitude to the role of the courts is expressed in a passage from Federalist 78: “It can be of no weight to say that the courts, on the pretense of a repugnancy, may substitute their own pleasure to the constitutional intentions of the legislature…. The courts must declare the sense of the law; and if they should be disposed to exercise WILL instead of JUDGMENT, the consequence would equally be the substitution of their pleasure to that of the legislative body.” But the “judgment” of Justice Roberts in this case seems to be very much an “exercise” of his “will.”

Should we therefore castigate Roberts as a hypocrite or ideologue? I don’t think so.

The problem is not that Roberts secretly wishes to impose his personal will on the law. Indeed, the decision seems to be the most restrained possible. It was hardly an instance of “judicial activism” or “legislating from the bench” given Robert’s presumptive political opposition to Obamacare. The problem arises when sweeping measures such as the Affordable Care Act come before the Court. Such laws are ambiguous. Continue reading →

Less than two months ago, President Obama claimed that speculators were (or at least might be) artificially driving up the price of oil—a notion that some politician or pundit brings up every time gasoline looks expensive. The idea fades when the market changes direction. Thus in recent weeks, economies worldwide took a turn for the worse and the price of oil came down a notch. Continue reading →

Krugman repeats the by now well-known argument on banks, as a riff on “It’s a Wonderful Life.” The Jimmy Stewart character makes “a risky bet on some complex financial instrument,” loses the money and causes his bank to collapse. The moral: banks should not be allowed to take on much risk because “they put the whole economy in jeopardy” and “shouldn’t be allowed to run wild, since they are in effect gambling with taxpayers’ money.”

The fact is, banks make money by taking risk. That’s always been the business model. Even Bailey Building and Loan in “It’s a Wonderful Life” makes risky home loans—one might think of them as subprime. Continue reading →

Fact number one is that in 2010 Congress passed the gigantic Dodd-Frank financial regulation law, which is being translated to thousands of specific rules by coteries of government bureaucrats. The Volcker rule against bank proprietary trading is the least of it. There are numerous new rules. None of these could have prevented the JP Morgan loss or even moderated it, as best I can tell. Continue reading →

My previous post about government restrictions on oil and gasoline transportation drew comments saying prices are set in a world market and the effect of United States policy is negligible. Numerous economic and geopolitical forces influence the price of oil, no question. That does not Continue reading →

Oil from North Dakota is selling at a record discount, according to a March 1st news item in the local paper, the Bismarck Tribune. By contrast, here in New York gasoline prices are near record highs. Between North Dakota and New York are thousands of miles but more crucially standing between us is a gigantic entity, the federal government.

With North Dakota’s Bakken and Three Forks shale formations producing at a rip roaring rate, the issue is getting the oil to refineries and from refineries to population centers. The Bismarck Tribune article quotes the State Mineral Resources Director, who said: “prices for North Dakota sweet crude generally mirrored West Texas Intermediate prices last year but began widening in January when President Barack Obama temporarily halted the $7 billion Canada-to-Texas Keystone XL pipeline, which would have carried 100,000 barrels of crude daily from North Dakota and Montana.”

Is the Federal Reserve a hotbed of trustbusters? Fed officials (as well as some academics) have been calling for forcible downsizing of big banks . “I am of the belief personally that the power of the five largest banks is too concentrated,” Dallas Federal Reserve Bank president Richard Fisher said a few days ago during a visit to Mexico, according to news reports. He’s expressed similar views before, as has Thomas Hoenig, former president of the Kansas City Fed.

Here on ThinkMarkets Jerry O’Driscoll, a Federal Reserve veteran, wrote: “There is no conceivable efficiency gain that justifies the risk these gigantic, risky institutions impose on all of us,” Continue reading →

Early in his career, long before he became a Nobel prizewinner and the household name for free market economist, Milton Friedman worked for the US Treasury. The following anecdote is from his 1998 memoir with his wife Rose, Two Lucky People. This revealing example of how public officials operate illustrates, in Friedman’s words, “the interaction between bureaucratic self-seeking and supposedly objective analysis.” It complements my previous post on whether politicians pursue the public good.

World War II had started. For Friedman and others at the Treasury, the main mission was to figure out how to finance the war effort while avoiding inflation. Continue reading →

Barack Obama sounded a number of themes in his 2012 State of the Union Address this week, all underpinned by the proposition that socioeconomic ills can be solved by interventionist government in general and his administration in particular.

Indiana governor Mitch Daniels, giving the Republican rebuttal, effectively replied to the main claims. He pointed to the failure of the President’s “grand experiment in trickle-down government.” Programs spend borrowed money in attempts to boost the middle class. “In fact, it works the other way: a government as big and bossy as this one is maintained on the backs of the middle class,” Mr. Daniels said.

Jamie Dimon, the chief executive of JP Morgan Chase, says regulatory policy is working against economic recovery and as such is contradictory. His complaint is about the new bank rules, but in fact government actions in myriad areas are at odds with each other.

As the old adage goes, be careful what you ask for, you might just get it. After the 2008 crisis it became fashionable to complain that too much trading is going on. There were calls in this and other countries to restrict financial transactions. And it happened. One example is the rule named after Paul Volcker in the 2010 Dodd-Frank law, banning depository banks’ trading on their own accounts (and also forbidding them from holding significant hedge fund or private equity interests).

Regulators are still in the process of determining how to implement the Volcker rule but the potential impact is already discernible. Likely victims include millions of Americans who save for their retirement and smaller companies that need to borrow money. Continue reading →

I watched a rather good debate this morning on the ABC News program This Week. The participants were journalist George Will and Congressman Paul Ryan (on the “right”) and Congressman Barney Frank and former Labor Secretary Robert Reich (“on the ‘left”). You can watch it now or simply read the transcript. The topic for the debate was “There is too much government in my life.”

I thought the “right” handled the economic questions very well. I was especially impressed (because I don’t know him as well) by Paul Ryan’s knowledge and debating skill. But I kept wishing that George Will was in one of his libertarian moods because the “left” exposed some glaring inconsistencies on matters of social and military policy. For whatever reason, Will played the good conservative in the debate (perhaps to avoid causing splits on the “conservative” side of the debate).

For those who enjoy trying to figure out what important thinkers might have thought about specific issues they never faced (and I am one of them!), the following letter I discovered will prove interesting and perhaps disconcerting to some.

Below is a brief excerpt from a letter that F.A. Hayek wrote to the journalist and political theorist Walter Lippmann in 1937.* The subject was the large modern corporation which Lippmann thought was prone to developing various degrees of monopoly power. This was a view shared by Frank H. Knight at this time, and Hayek may have agreed, at least to some extent.

The issues were: (1) Why was this the case? and (2) Was it consistent with (classical) liberalism for the government to do something about it? Continue reading →